Alibaba structure poses 'major risks' to investors

US report warns over complex legal contracts linking foreign stakes to Chinese internet firms

PUBLISHED : Saturday, 21 June, 2014, 12:53am
UPDATED : Saturday, 21 June, 2014, 1:50am

Shareholders in the United States face "major risks" from investing in Chinese internet companies such as Alibaba Group Holding that use variable interest entities (VIEs), according to a US congressional commission report.

Risks are associated with these entities because the structures create holding companies to link foreign investors to Chinese firms through a set of complex legal contracts, according to a report released on Wednesday by the US-China Economic and Security Review Commission.

There was a "high probability" Chinese courts would not uphold those contracts, the report said.

Alibaba, now preparing for what could be the largest initial public offering in the US, would follow Chinese internet companies Baidu and Weibo in securing a US listing using the structure.

Such entities, usually based in tax havens such as the Cayman Islands, helped circumvent Chinese restrictions on access to foreign capital while putting investors at risk from their legal complexity, the commission said.

"The legal contracts that serve as the basis of the structure are enforceable only in China," the report said. "As internet giants Alibaba, Baidu and Weibo become synonymous with 'Chinese Amazon', 'Chinese Google' and 'Chinese Twitter', risks could mount for unsuspecting US investors who buy into their precarious VIE structures."

Revenue generated through Alibaba entities only accounted for about 12 per cent, or 6.17 billion yuan (HK$7.76 billion), of sales in the year to March, according to its US Securities and Exchange Commission filing.

In a review of Baidu's variable structure last month, Moody's Investors Service found the Chinese company could manage the risks "because the founders and top executives own significant stakes in both the onshore VIEs and the offshore entities".

In addition, the majority of its cash flow resided offshore, it said.

Risks inherent in the structure have been disclosed to investors by Chinese companies, including Alibaba, as part of their listing processes, according to the report.

The variable interest entities structure is required because foreign ownership of certain types of internet businesses, such as online information services, is subject to restrictions under Chinese laws, and foreign investors are generally not permitted to own more than 50 per cent of the equity interests in a value-added telecommunications service provider.

The commission that published the report was created by the US Congress in October 2000 to monitor the national security implications of the Sino-US trade and economic relationship, and to provide recommendations to Congress for legislative or administrative action.

The report said Washington should encourage Beijing to remedy the risks with the entities by eliminating internet restrictions, liberalising China's financial markets, improving its rule of law and clarifying the legal status of VIEs.